Cliff Wachtel, CPA, is currently the Director of Market Research, New Media and Training for Caesartrade.com, a fast growing forex and CFD broker. He covers a variety of topics including global market drivers, forex, currency hedged and diversified income investing, and is currently working on a... More

A trader’s strategy guide to prior week’s market movers and their lessons for the coming week for traders of all major asset classes via both traditional instruments and binary options

Markets moved mostly with headlines and speculation about the EU summit, all else was secondary.

1. EU Summit

From Monday to Wednesday risk assets traded in a tight range with modest movements up or down. Then came Thursday’s plunge, driven by:

The ECB’s ending hopes for a big financial aid plan to contain the debt crisis

Germany’s rejecting key proposals to strengthen the EZ’s bailout fund

Friday’ news didn’t alter this picture.

In sum, the much anticipated summit appeared to utterly fail to provide what markets wanted to see - assurance that there would be all the cash needed to insure against sovereign defaults and the banking collapse and deep recession likely to follow. On the surface

Yet, as of the close Friday, risk assets were rebounding higher, despite any obvious reason for the optimism. Let’s take a closer look at the prior week’s top market movers, and also try to discern why risk assets held steady despite having every reason to sell off

Let’s take a closer look.

Falls Far Short of Final EU Crisis Resolution

If this was supposed to be the summit that ended the EU crisis, then the summit was an unqualified failure. None of the steps believed needed to address the root problems were taken.

-No agreement on fiscal integration. Yes, steps were taken in that direction, as the agreement committed the leaders to enacting a “fiscal compact” and to work towards a “common economic policy,” however thus far all we have are these vague phrases. Once again, just another plan to make a plan.

--Details are missing (as usual for EU summit agreements)

--There was nothing thus far stated that suggests enforcement of spending and debt limits will be any more successful than under the Maastricht treaty, which was supposed to do the same thing and was ignored from the start.

-No massive commitment of cash to prevent Spain and Italy from defaulting, which is what markets really wanted to see.

--Nor will there be any ECB bond buying to put a ceiling on GIIPS bond rates, with ECB President Draghi reaffirming a €20 billion ($27 billion) limit on ECB bond-buying per Reuters.

-No bold new initiatives to spur growth in the GIIPS economies.

Instead, EU leaders will consider enlarging the €500 billion ($667 billion) in funding available to the ESM in March 2012, and lending another to €200 billion ($267 billion) in additional funding to the IMF.

In the end, Merkel and Sarkozy continue to insist that the key to ending the crisis is regulation, while markets are waiting for commitments of cash to prevent default.

Ultimately, we seriously question

--How many nations will truly be willing to cede control over their budgets (and thus effective sovereignty)

--Whether there is enough political will anywhere to come up with enough cash to backstop Italian and Spanish sovereign debt.

Note that Germany remains dead set against any kind of debt liability sharing like that of Eurobonds, and also wants treaty changes to allow member nations to leave. This feeds our suspicion that Germany could ultimately be one of the nations to leave if it can find a way to retain trade advantages of the EU without the burdens of other nations’ debts.

Regardless of how markets may be reacting today, there is no reason to believe the crisis has seen its worst days.

Yet, risk asset market were up Friday, despite having every reason to conclude the crisis is still very much on. Why?

Possible Explanations for Friday’s Rally

Here’s the possible explanations that I could find.

1.No More Bondholder Losses

Those leaders who had insisted that private sector (financial institutions mostly) holders of sovereign debt bear part of the cost of any bailouts via haircuts (partial defaults) dropped this demand. Many correctly see its introduction last July as the cause of the latest crisis. Why should anyone accept low yields on these bonds if in fact they weren’t virtually risk free?

As regards private-sector involvement, we have made a major change in our doctrine: from now on we will strictly adhere to the IMF principles and doctrines,” and added “or, to put it more bluntly, our first approach to PSI, which had a very negative effect on debt markets is now officially over.

So elimination of risk of EU imposed bondholder losses should be great for the banks. But what if, regardless of EU policy, the GIIPS actually can’t or won’t pay anyway? A Greek default is still a matter of if, not when. Once we get one default, others become much more likely as GIIPS yields rise, bank lending freezes up again, etc.

In other words, dropping PSI (private sector involvement) is meaningless for preventing bondholder losses unless there is some new financial “bazooka” to provide the cash when needed to prevent defaults.

2. Crouching Tiger, Hidden Bazooka?

Global Macro Monitor argues that’s exactly the point. By explicitly ending PSI, the EU is implying that public sector bailouts will continue via an implied bazooka whenever the GIIPS need someone to buy their bonds, which are used to repay the holders of maturing bonds.

So why aren’t EU leaders being more explicit? An openly declared bazooka would do a better job of calming markets. In a recent post, the writer offers two reasons:

DISCLOSURE /DISCLAIMER: THE ABOVE IS FOR INFORMATIONAL PURPOSES ONLY, RESPONSIBILITY FOR ALL TRADING DECISIONS LIES SOLELY WITH THE READER. IF WE REALLY KNEW WHAT WOULD HAPPEN, WE WOULDN’T BE TELLING YOU FOR FREE, NOW WOULD WE?

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